What are Retained Earnings?

Retained Earnings (RE) are the accumulated portion of a business’s profits that are not distributed as dividends to shareholders but instead are reserved for reinvestment back into the business. Normally, these funds are used for working capital and fixed asset purchases (capital expenditures) or allotted for paying off debt obligations

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What are Retained Earnings?

Retained Earnings (RE) are the accumulated portion of a business’s profits that are not distributed as dividends to shareholders but instead are reserved for reinvestment back into the business. Normally, these funds are used for working capital and fixed asset purchases (capital expenditures) or allotted for paying off debt obligations

The Purpose of Retained Earnings

Retained earnings represent a useful link between the income statement and the balance sheet, as they are recorded under shareholders’ equity, which connects the two statements. The purpose of retaining these earnings can be varied and includes buying new equipment and machines, spending on research and development, or other activities that could potentially generate growth for the company. This reinvestment into the company aims to achieve even more earnings in the future.

If a company does not believe it can earn a sufficient return on investment from those retained earnings (i.e., earn more than their cost of capital), then they will often distribute those earnings to shareholders as dividends or conduct a share buybacks.

What is the Retained Earnings Formula?

The RE formula is as follows:

RE = Beginning Period RE + Net Income/Loss – Cash Dividends – Stock Dividends

Where RE = Retained Earnings

Beginning of Period Retained Earnings

At the end of each accounting period, retained earnings are reported on the balance sheet as the accumulated income from the prior year (including the current year’s income), minus dividends paid to shareholders. In the next accounting cycle, the RE ending balance from the previous accounting period will now become the retained earnings beginning balance.

The RE balance may not always be a positive number, as it may reflect that the current period’s net loss is greater than that of the RE beginning balance. Alternatively, a large distribution of dividends that exceed the retained earnings balance can cause it to go negative.

How Net Income Impacts Retained Earnings

Any changes or movement with net income will directly impact the RE balance. Factors such as an increase or decrease in net income and incurrence of net loss will pave the way to either business profitability or deficit. The Retained Earnings account can be negative due to large, cumulative net losses. Naturally, the same items that affect net income affect RE.

Examples of these items include sales revenue, cost of goods sold, depreciation, and other operating expenses. Non-cash items such as write-downs or impairments and stock-based compensation also affect the account.

How Dividends Impact Retained Earnings

Distribution of dividends to shareholders can be in the form of cash or stock. Both forms can reduce the value of RE for the business. Cash dividends represent a cash outflow and are recorded as reductions in the cash account. These reduce the size of a company’s balance sheet and asset value as the company no longer owns part of its liquid assets.

Stock dividends, however, do not require a cash outflow. Instead, they reallocate a portion of the RE to common stock and additional paid-in capital accounts. This allocation does not impact the overall size of the company’s balance sheet, but it does decrease the value of stocks per share.

Learn more: how to forecast a company’s balance sheet.

End of Period Retained Earnings

At the end of the period, you can calculate your final Retained Earnings balance for the balance sheet by taking the beginning period, adding any net income or net loss, and subtracting any dividends.

Example Calculation

In this example, the amount of dividends paid by XYZ is unknown to us, so using the information from the Balance Sheet and the Income Statement, we can derive it remembering the formula Beginning RE – Ending RE + Net income (-loss) = Dividends

 

 

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